ANALYSIS-U.S. Treasuries rout may be far from over

September 05, 2013|Reuters

By Luciana Lopez and Jennifer Ablan

NEW YORK, Sept 5 (Reuters) - It has already been a horridyear for investors in U.S. Treasuries - and it could easily getmuch worse.

U.S. government bonds ended August with their fourthstraight monthly loss, down 3.43 percent on a total return basisin the four months, their worst such stretch since 1996,according to the Barclays Aggregate U.S. Treasury Index.

Yields on benchmark 10-year Treasury notes havesurged by 1.29 percentage points since their low-water markaround 1.6 percent in early May. But even at 2.89 percent onWednesday, yields could move even higher, and prices lower, whenthe U.S. Federal Reserve pulls back on its $85-billion-a-monthbuying of Treasuries and mortgage-backed securities, a processlargely expected to begin with the Sept. 17-18 meeting of theFederal Open Market Committee.

"I don't know what the magic number is, but Treasury yieldswill be much higher than they are now by year-end," said DanFuss, vice chairman and portfolio manager at Loomis Sayles,which has $190 billion in assets.

Altogether, there is plenty of scope for 10-year yields notjust to breach the psychologically key 3 percent barrier - alevel unseen since July 2011 - but to overshoot and notchfurther multi-year highs in coming months.

This matters because U.S. government debt is used as abenchmark for pricing a huge range of other interest rates, fromhome mortgages to complex derivatives around the world.

The Fed's purchases have swollen its balance sheet to arecord $3.6 trillion, but the Fed isn't looking to stop itsbuying just because it owns so much of the market.

By several measures, the U.S. economy is picking up steam,meaning the Fed doesn't need to prop up the economy as much.Growth in U.S. home prices and manufacturing orders, includingrobust auto sales, have been among the positive economic signs.Jobs growth has been solid, though unspectacular.

Price pressures could also speed up, potentially promptingthe Fed down the road to pay more heed to the inflation half ofits dual mandate of promoting maximum employment and stableprices.

"The market has underestimated the risk that inflationpressure actually may not continue subsiding and may even turnaround," said Pippa Malmgren, president of Principalis AssetManagement, who advises investors on policy and political risk. She pointed to price pressures in emerging markets that couldbleed into industrialized countries.

Recent inflation data was strong enough to prompt even somelongtime inflation bears to throw in the towel.

"I've been in the deflation camp for two decades ... butstrongly feel it is time to move on," said David Rosenberg,chief economist and strategist of Gluskin Sheff and Associates,to clients last month.

While worries about a potential U.S. military strike againstSyria took yields off their two-year highs recently, Treasuriesare selling off again now that such action has been delayed.

An unexpectedly long engagement in Syria could rekindle abid for Treasuries. And should another standoff between theWhite House and Congress over raising the debt limit roil othermarkets, Treasuries could benefit from a flight to safety evenagainst the risk of a technical default, as happened in 2011.

Still, it largely comes down to the Fed. With data pointingto an improving jobs market and faster second-quarter growth,some Fed speakers say it is time to wean the economy off thebank's substantial help.

Most economists in a Reuters poll see tapering of the bondbuying program starting at the bank's meeting later this month.

MORE THAN JUST TREASURIES

The weakness has not been limited to government bonds. Morebroadly, with corporate debt and mortgage-backed securities,this year has been the worst for bonds on record, with theBarclays U.S. Aggregate Bond Index, the most widelytracked bond market benchmark, down 3.2 percent to date on atotal return basis. If it doesn't improve over the rest of theyear, that decline will exceed the previous worst year in theindex's 40-year record, which was in 1994 with a loss of 2.9percent.

And investors, from big institutional funds to sovereignaccounts, are not waiting for a turnaround. According to datafrom Lipper, a Thomson Reuters unit, taxable bond funds haveseen outflows four of the past five weeks.

The Pimco Total Return Fund, the world's largest bond fund,had $7.7 billion in net cash outflows in August, marking thefourth straight month of withdrawals, according to Morningstar.